A United States appeals court said that the Commodity Exchange Act’s prohibition against spoofing and other conduct could potentially apply in connection with a lawsuit against a US-based trading firm brought by five Korean residents related to transactions involving the Kospi 200 futures contract on the Korean Exchange’s night market. The Court held that, because KRX used CME Globex as its nighttime matching engine, Kospi 200 futures trades matched overnight could potentially be considered irrevocable in the United States, thus warranting application of the CEA. The court took this view even though such trades were KRX trades and not finalized until the following day when they were settled through the KRX Clearinghouse.Separately, most of the defendants in an anti-fraud enforcement action related to virtual currencies brought by the Commodity Futures Trading Commission objected to the Commission’s jurisdiction. Within a few days, however, some of the same defendants consented to the agency’s entry of a preliminary injunction without prejudice to their right to assert their jurisdictional claim in later arguments. As a result, the following matters are covered in this week’s edition of Bridging the Week:

Federal Appeals Court Holds Night Futures Trades on Korea Exchange Matched On CME Globex Potentially Subject to Commodity Exchange Act: The US Court of Appeals in New York held that Tower Research Capital must stand trial in connection with an amended complaint filed by five Korean citizens alleging that the firm and its founder, Mark Gorton, engaged in spoofing-type conduct in Kospi 200 stock index futures contracts cleared and settled on the Korean Exchange in violation of US law and New York’s prohibition on unjust enrichment.

Last year a federal district court in New York dismissed plaintiffs’ action (for a second time), holding that application of the relevant law (the Commodity Exchange Act) would constitute an “impermissible extraterritorial application” and that plaintiffs had no evidence of a direct relationship with defendants necessary to sustain a claim of unjust enrichment. The appellate court reversed this decision. (Click here to access a copy of the district court’s opinion.)

According to plaintiffs – who filed this action as a class action – the defendants engaged in spoofing-type conduct from January 1 through December 31, 2012, to manipulate the price of Kospi 200 futures for defendants’ own benefit to the detriment of plaintiffs. Each of the relevant transactions was executed on the KRX night market when the KRX was closed for business. During this time, KRX members or traders authorized by such members entered orders that were matched with anonymous counterparties through the Chicago Mercantile Exchange’s Globex electronic trading platform. These trades then cleared and settled on the KRX the next morning after the KRX opened. (Click here for details regarding the KRX night market and CME Globex.)

In their complaint, plaintiffs conceded that they could not identify with precision that any of their counterparties was Tower, but alleged there was a greater than 99.99 percent probability that Tower was a direct counterparty at least once. Moreover, even if Tower was not a counterparty, the plaintiffs claimed they traded at artificial prices caused by the defendants’ alleged spoofing activity. Plaintiffs claimed that Tower earned approximately US $14.1 million as a result of its purported illicit conduct. (Click here to access a copy of Plaintiffs' First Amended Complaint.)

Relying on a 2010 Supreme Court decision (Morrison v. National Australia Bank; click here to access) the district court held that, for futures transactions to be subject to the Commodity Exchange Act, parties to such transactions must “incur irrevocable liability” in the United States or on a US exchange. However, the district court ruled that this was not the case for transactions executed during the KRX night market because trades there were only final when they were cleared and settled on KRX the next day (and not at the moment they were matched on CME Globex). Moreover, the district court held that plaintiffs failed to sufficiently allege that CME Globex was a “domestic exchange” as it is not distinctly registered as an exchange with the Commodity Futures Trading Commission, like CME itself.

The appellate court reversed the district court, however, because, in its view, there were “plausible allegations” that parties to KRX night market transactions incurred irrevocable liability in the United States and this was a sufficient basis for plaintiffs to invoke the Commodity Exchange Act and avoid defendants’ motion to dismiss. This was because, said the appellate court, plaintiffs sufficiently argued that KRX night market trades “bind the parties on matching.” The appellate court also held that, even if there was no direct connection between plaintiffs and defendants on any trade, plaintiffs argued they sustained damages because of defendants’ trading which caused them harm and unjustly enriched the defendants.

My View: A futures contract is only irrevocable after it is executed and accepted for clearing. Until both steps occur, and a clearinghouse is substituted as the counterparty to each of the initial parties to a trade, a futures contract is not fully created let alone binding (See, for example, CME Clearing Rule 804; click here to access.) A complete futures contract = execution + clearing; the two components should be inseparable but both are required.

Plaintiffs’ amended complaint effectively conceded that, in connection with Kospi 200 futures contracts on the KRX night market, no transactions were finalized until after their matching on CME Globex. Until the contracts were settled in Korea the following day, the transactions were, at best, “essentially binding contracts,” acknowledged the plaintiffs (emphasis added; the plaintiffs relied on a CME Group publication – click here to access (Q/A 9)). However, “essentially binding contracts” and irrevocable contracts are two different things.

As plaintiffs pointed out in their complaint, all KRX night transactions had to be placed through the KRX trading system in the first place. Moreover, both the plaintiffs and defendants had to maintain accounts with licensed Korean brokers to gain access to the KRX trading system, and despite the transactions being matched on CME Globex, the trades were KRX transactions subject to KRX's requirements through and through. Even after the transactions were routed to and matched on CME Globex, the transactions were not completed until the following trading day in Korea when the KRX Clearinghouse substituted itself as the counterparty to each of the initial persons’ trades. As a result, no fully created and binding futures contracts could have been created until such time.

Despite KRX’s use of CME Globex as a platform to match transactions, the nexus of the relevant trades to the United States was remote and the Commodity Exchange Act should not have applied. The district court in this case got it right; the US Court of Appeals got it wrong.

Defendants in CFTC Crypto Case First Argue Commission Lacks Anti-Fraud Authority Then Some Consent Voluntarily to Jurisdiction: On March 30, My Big Coin Pay, Inc. (MBCP), Randall Crater and six so-called "relief defendants" claimed that the CFTC lacked authority to bring an enforcement action against them charging fraud in connection with the offer of a virtual currency token, because the digital token was not a commodity under applicable law (the Commodity Exchange Act) and thus the Commission lacked jurisdiction. However, without prejudice to this argument, subsequently on April 5, some of the defendants consented to imposition of a preliminary injunction against them.

In January, the CFTC filed an enforcement action against MBCP, Mr. Crater, Mark Gillespie and the six relief defendants for allegedly engaging in a virtual currency scheme that misappropriated approximately US $6 million from 28 or more persons from at least January 2014 through January 2018. (Click here for details on the CFTC’s enforcement action in the article “CFTC Sues Unregistered Company and Promoters of Fake Virtual Coin for Alleged Fraud and Operating Purported Ponzi Scheme” in the January 28, 2018 edition of Bridging the Week.)

The defendants filed a motion to dismiss the CFTC’s complaint claiming that it lacked jurisdiction under applicable law. According to the defendants, the CFTC may only bring an enforcement action alleging fraud in connection with the offer and sale of a commodity transacted in interstate commerce. However, said the defendants, their virtual currency – named “My Big Coin” – was not a commodity as defined under applicable law because it was not one of the specifically enumerated 30 commodities in the CEA’s definition and it was a not a service, right or interest “in which contracts for future delivery are presently or in the future dealt in.” (Click here for the definition of a commodity under the CEA, 7 U.S. Code §1a(9).) According to the defendants, solely Bitcoin qualifies as a commodity as there are currently futures contracts trading based on that virtual currency only.

However, days after filing a memorandum of law in support of their motion, some of the defendants, including Mr, Crater, consented to the imposition of a preliminary injunction and other relief, although they conceded jurisdiction and venue solely “for the limited purposes” of the court order.

Previously, Maksim Zaslavskiy moved to dismiss a criminal complaint that had been filed against him in November 2017, charging that he engaged in illegal unregistered securities offerings and securities fraud in connection with the offering of digital tokens through initial coin offerings organized by two of his companies, REcoin Group Foundation, LLC and DRC World, Inc. Among other things, Mr. Zaslavskiy claimed in his motion that the digital tokens he tried to create were not securities but cryptocurrencies, and that all currencies, fiat and otherwise, are not securities under applicable law. (Click here for background in the article “Federal Court, Treasury and SEC Provide Further Guidance on Cryptocurrencies; Subject of Criminal Complaint for ICO Asks Court to Dismiss Prosecution Claiming Cryptocurrencies Are Not Securities” in the March 11, 2018 edition of Bridging the Week.)

Separately:

SEC Seeks to Halt Another ICO: The Securities and Exchange Commission brought a legal action against Sohrab Sharma and Robert Farkas in connection with a purported illicit initial coin offering that purportedly raised more than US $32 million from investors last year. The SEC claimed, in its civil charges, that the ICO constituted the illegal sale of securities that were neither registered as securities or lawfully exempt. The SEC charged that the defendants promoted their coin – the Centra or CTR Token – by falsely claiming relationships with well-known financial institutions such as Visa, MasterCard and The Bancorp, untruthfully holding out that the chief executive officer of Centra was an experienced businessman who had invested “a lot of capital originally” to start up Centra when such a person did not exist at all, and falsely promising revenue shares to investors. The SEC's enforcement action was brought in a federal court in New York City. The Commission seeks an injunction against the defendants, disgorgement and fines. Separately, the US Attorney’s Office in New York announced the arrest of Mr. Sharma and Mr. Farkas in connection with criminal charges filed against them for the same essential conduct. If convicted, each individual could face up to 20 years’ imprisonment for each of three charges levied against them, and 5 years’ for a fourth charge. (Click here to access a copy of the SEC complaint, and here for a copy of the criminal complaint.)

India Central Bank Impedes Virtual Currency Conversions: The Reserve Bank of India determined that, with immediate effect, no entity regulated by the RBI may begin dealing or providing services to any individual or business dealing with or settling virtual currencies. Entities already providing such services must exit within a specified time pursuant to a circular that will be issued later. The RBI also announced it would soon be providing guidance on the desirability and feasibility to introduce a central bank digital currency. (Click here for a copy of the RBI’s statement.)

SEC to Evaluate Cboe BZX Bitcoin Futures ETFs: The SEC issued a notice that it is currently evaluating two proposed exchange-traded funds sought to be listed on the Cboe BZX exchange principally based on Bitcoin futures traded on the Cboe Futures Exchange (CFE). Among other things, the SEC seeks public comment on the proposal by the Exchange, that if the funds cannot invest in Cboe Bitcoin futures, it may invest in listed Bitcoin swaps or over-the-counter Bitcoin swaps. The SEC also seeks views on the funds’ valuation policies if the Bitcoin blockchain forks and the effect of substantial margin requirements on Bitcoin futures’ liquidity. Comments should be submitted by 21 days after publication of the SEC’s notice in the Federal Register, and rebuttal comments, within 35 days. (Click here to access the SEC’s notice.) Two weeks ago, the SEC announced it would also consider the application of NYSE Arca to list and trade shares of exchange-traded funds based on Bitcoin futures contracts traded on either the CFE or the Chicago Mercantile Exchange. (Click here to access the article “SEC Considers NYSE Bitcoin Futures ETFs” in the April 1, 2018 edition of Bridging the Week.)

AUSTRAC Requires Digital Currency Exchanges to Register: The Australian Transaction Reports and Analysis Centre (AUSTRAC) – the Australian equivalent of the US Financial Enforcement Crimes Network – reminded digital currency exchanges (DCEs) doing business down under that, effective immediately, they must adopt and maintain an anti-money laundering program, identify and verify the identities of their customers, report suspicious transactions to AUSTRAC, and maintain records for seven years. Also, all new DCE businesses must register with AUSTRAC, and all existing DCE businesses must register by May 14. (Click here for details.)

Arizona Okays Blockchain Corporate Records: Arizona became the second state to permit corporations to maintain and share data on a blockchain. The first state, Delaware, enacted new provisions of law effective August 1, 2017, that authorized corporations to maintain certain of their required records, including stock ledgers, on electronic networks or databases, including distributed electronic networks, such as the blockchain. (Click here for details in the article “New Delaware Law Authorizes Companies to Manage Corporate Records Using Distributed Ledger Technology” in the August 6, 2017 edition of Bridging the Week. Click here for a copy of the new Arizona law.)

SEC Obtains Freeze Related to Cryptocurrency Company Stock Sales: The SEC obtained a court order freezing US $27 million of trading proceeds related to a purported illegal distribution of restricted securities of Longfin Corp. by Venkata Meenavalli, its chairman and chief executive officer, and three other affiliates, from December 2017 and February 2018. The individuals allegedly sold their restricted stock without registering it or with a valid exemption after its price increased dramatically following the company’s acquisition of Ziddu.com from another company mostly owned by Mr. Meenavalli. Ziddu.com promoted itself as a “blockchain-empowered solutions provider.” (Click here for a copy of the SEC complaint.)

My View: Although I have often exaggerated in public speeches for humor that the CEA definition of “commodity” under applicable law is any noun, the breadth of the definition is truly extensive. As most of the defendants in My Big Pay Coin pointed out in a memorandum to the court, the definition includes 30 specifically enumerated commodities and all services, rights and interests in which contracts are presently or in the future dealt in. However, the definition of a commodity also includes “all other goods and articles” except for onions and motion picture box office receipts. This clause stands alone in the CEA definition of commodity and is not modified by the qualification, "...in which contracts for future delivery are presently or in the future dealt in." As a plain review of the placement of commas and the two uses of word "and" make clear in the CEA definition of commodity, only the phrase "...and all services rights and interests" is modified by the phrase "in which contracts for future delivery are presently or in the future dealt in."

Thus, the definition of commodity is very broad. It includes (1) 30 enumerated commodities plus all (2) other goods and articles, as well as (3) "all services, rights and interests... in which contracts for future delivery are presently, or in the future dealt in."

Relying on the CEA definition of a commodity, a federal court in Brooklyn, New York, recently upheld the CFTC’s authority to exercise its enforcement power over fraud to virtual currencies sold in interstate commerce and granted the CFTC an injunction against Patrick McDonnell and Cabbagetech, Corp. (Click here for details in the article “A Court, Treasury and the SEC Confirm Substantial Overlap in US Jurisdiction of Cryptocurrencies” in the March 8, 2018 edition of Between Bridges.) Although, in so ruling, the court incorrectly tied "goods and services" to the phrase "in which contracts for future delivery are presently or in the future deal in", the court also expressly held that “[v]irtual currencies are ‘goods’ exchanged in a market for a uniform quality and value.”

The fact that the CEA definition of commodity excludes box office receipts “or any index, measure, value, or data related to such receipts” from the reference to “all other goods and articles,” evidences the intent of Congress to view the term “goods and articles” broadly. Indeed, the exclusion of box office receipts specifically suggests that all other types of receipts are included in the definition of a commodity regardless of form. Presumably this would include physical fiat currencies, electronic credits of fiat currency and all other potential types of payments that could be reflected in receipts – e.g., payments by all virtual currencies.

More Briefly:

FinCEN Publishes Customer Due Diligence Requirements’ Frequently Asked Questions: A few weeks prior to the May 11 implementation date of its new requirements regarding due diligence for beneficial owners of legal entity accounts, the Financial Enforcement Crimes Network of the US Department of Treasury issued comprehensive guidance in the form of frequently asked questions. Among other things, the FAQs addressed how firms should determine whether a person is a 25 percent or more legal entity owner where there is a complex ownership structure and what constitutes the opening of a new account by a legal entity customer. (Click here for background regarding FinCEN's new due diligence requirements in Compliance Weeds 2 accompanying the article, "Broker-Dealer, CEO and AML Compliance Officer Settle SEC Charges for Not Filing Suspicious Activity Reports in Response to Red Flags" in the April 1, 2018 edition of Bridging the Week.)

Trader Criminally Charged for Alleged Spoofing Prevails in Effort to Quash Evidence of Front-Running at Trial: Andre Flotron, a former metals trader for UBS Investment Bank and the defendant in a criminal action charging him with engaging in spoofing-type activities, prevailed in a motion to preclude the prosecution from introducing potential evidence of his engagement in front-running activity into his upcoming trial. The judge, in a federal court in Connecticut, ruled that nothing precludes the prosecution from introducing such evidence should Mr. Flotron himself “open the door” to such evidence at trial. (Click here for background on Mr. Flotron’s criminal action in the article “Spoofing Case Filed in Connecticut Against Overseas-Based Precious Metals Trader” in the September 17, 2017 edition of Bridging the Week.)

CME Group Exchanges Sanction Traders for Disruptive Trading, Violating Relation Position Requirements for EFRPs, and Position Limits Offenses: The Business Conduct Committee of the Commodity Exchange, Inc. agreed to accept a fine of US $35,000 and a 10-business-day all exchange access suspension from Corey Flaum to resolve disciplinary charges that from January through July 2016, he engaged in spoofing-type conduct. The New York Mercantile Exchange BCC similarly accepted a penalty of US $25,000 and a four-month all exchange access suspension from Chao Ho to resolve charges that he also engaged in spoofing-type trading. Mr. Ho was also required to disgorge a profit of US $1,752. Separately, City Financial Investment Company Ltd. agreed to settle a NYMEX disciplinary action by paying a fine of US $30,000 for a one-day position limit violation in Henry Hub Natural Gas Look-Alike Last Day Financial Futures, while World Fuel Services Singapore PTE Ltd. consented to settle charges that, in connection with three exchange for related position transactions, it failed to enter into an over-the-counter swap or other OTC derivative transaction. The firm agreed to pay US $10,000 in connection with this settlement.

SEC Rewards Whistleblower Who First Alerted Another Regulator: The Securities and Exchange Commission awarded US $2.2 million to a whistleblower who first reported a possible regulatory breach to another federal agency. However, as required by applicable law, the whistleblower subsequently reported relevant information to the SEC within 120 days and, according to the Commission, “provided substantial cooperation” in the subsequent investigation. This award was the first use of a “safe harbor” in the SEC’s relevant whistleblower rules that authorizes the agency to reward a whistleblower who provides information to another federal agency prior to providing the information to it. (Click here to access the relevant rule, SEC Rule 21F-4(b)(7).)

CME Group Expands Acceptable Types of Collateral to Satisfy House Performance Bond Requirements: CME Group announced that, going forward, it will accept a new type of collateral to meet performance bond requirements in the house origin for futures and options products – a letter of credit issued by a bankruptcy-remote trust that is fully collateralized and secured by US treasury securities – as part of the exchanges’ Prefunded Treasury Facility program. Clearing members can satisfy up to 75 percent of their performance bond requirements through posting of a letter of credit issued as part of the PTF program. CME Group developed the PTE program in collaboration with GCSA Capital.

NFA Reminds Members of Some Annual and Ongoing Requirements: The National Futures Association issued a reminder to members of their obligations to perform certain ongoing obligations. These include completing the annual questionnaire on the anniversary of their membership date and, on an ongoing basis, keeping information updated on their registration Form 7-R.

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of April 7, 2018. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or other employees.

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ABOUT GARY DEWAAL

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.